The Court reversed (6-2) the Third Circuit ruling and held that bankruptcy courts may not approve structured dismissals that provide for distributions that do not conform to the ordinary priority rules, even as a “rare case” exception.

To briefly revisit the facts, the debtor was a financially-troubled trucking company. A private equity firm acquired the company in a leveraged buy-out and refinanced the company’s debt. Shortly thereafter, the company defaulted on these obligations and filed a Chapter 11 bankruptcy petition.

The company terminated most of its employees, including its truck drivers, just one day before filing the petition, which gave rise to a multimillion dollar priority wage claim. Despite the truckers’ priority status, distributions to the company’s senior lenders would have drained the company’s limited coffers, leaving nothing for the truckers.

At the same time, the unsecured creditors’ committee pursued fraudulent transfer claims against the senior lenders. Eventually, the senior lenders and the committee entered into a settlement agreement that would shuffle a few million dollars to the general unsecured creditors, thus bypassing the truckers’ priority claims. The bankruptcy court approved the settlement over the truckers’ objection and the district court affirmed that decision.

In a “close call,” the Third Circuit upheld the lower courts’ decisions, but stressed that deviation from the statutory priority scheme should occur only in those rare circumstances when bankruptcy courts “have specific and credible grounds to justify deviation.” Much of the Third Circuit’s reasoning attached to the simple fact that – whether the settlement was allowed or disallowed – the truckers would, in the court’s estimation, walk away empty-handed.

The Supreme Court disagreed. As Justice Breyer explained for the majority, the bankruptcy court cannot disregard the statutory priority scheme, at least not in the context of a structured dismissal.

A distribution scheme ordered in connection with the dismissal of a Chapter 11 case cannot, without the consent of the affected parties, deviate from the basic rules that apply under the primary mechanisms the Code establishes for final distributions of estate value in business bankruptcies.”

In reaching its conclusion, the Court reinforced that the priority rules are “a basic underpinning of business bankruptcy law” and “fundamental.” Admittedly, the structured dismissal statute gives bankruptcy courts a limited authorization to alter the status quo ante “for cause.” The Court ruled that flexibility does not extend to non-consensual modifications of the priority rules. Indeed, the Court suggested, departures from the status quo should only be permitted insofar as they are designed to protect third parties who reasonably relied on any modifications made throughout the course of the bankruptcy proceedings.

A dissent (authored by Justice Thomas and joined by Justice Alito) did not take aim at the majority’s reasoning but, instead, took umbrage with a perceived bait-and-switch. In Justice Thomas’ view, the Court granting certiorari on a particular question – whether a bankruptcy court may authorize the distribution of settlement proceeds in a manner that violates the statutory priority scheme – but that the truckers argued and the majority answered the related but narrower question of whether a Chapter 11 case may be terminated by a structured dismissal that distributes estate property in violation of the priority scheme.

The dissent underscores an important take-away. The Court’s determination that bankruptcy courts may not depart from the statutory priority scheme, even in rare circumstances, applies only to cases concluding with a structured dismissal. The practice of a secured creditor bypassing an intervening class and “gifting” proceeds to a lower class of creditors in other situations (e.g. plan confirmations, liquidations) remains a fair and fertile battleground.

In an earlier blog piece we reported on the Third Circuit’s 2015 decision in In re Jevic Holding Corp. where the Court approved a settlement, implemented through a structured dismissal, which allowed junior creditors to receive a distribution prior to senior creditors being paid in full. The decision was appealed and the Supreme Court agreed to hear the case and decide whether structured dismissals are permissible in bankruptcy. More to come…

Today’s U.S. Supreme Court decision in Commonwealth of Puerto Rico v. Franklin California Tax-Free Trustputs an end to one of Puerto Rico’s multi-pronged efforts to deleverage itself. Given the comprehensiveness of the First Circuit’s intermediate appellate opinion upholding the district court’s invalidation of Puerto Rico’s Recovery Act, it was surprising that the highest court took the case, a decision apparently prompted by Justice Sotomayor’s interest in obtaining a reversal. Comments of some other Justices at oral arguments raised the possibility of Sotomayor attracting a majority for the proposition that the preemption provisions of Section 903 of the U.S. Bankruptcy Code were inapplicable to Puerto Rico, but in the end only Justice Ginsburg joined what turned out to be Sotomayor’s dissenting opinion in a 5-2 ruling upholding the relegation of the Recovery Act to the dustbins of history.

As we have written previously, the Recovery Act was damaged goods from the beginning: even if the fairly clear preemption argument had not prevailed, the Contracts Clause constraints on non-federal bankruptcy legislation would have severely constrained, if not eliminated, the effective use of the Recovery Act to break bond contracts. In any event, the Recovery Act, and the Supreme Court’s decision, were a couple weeks away from being moot, as it appears evident that Congress will pass PROMESA, the federal oversight and debt restructuring legislation that has always constituted the logical legal mechanism for those favoring a less chaotic denouement to Puerto Rico’s debt woes.

A few thoughts on Tuesday’s oral arguments before the U.S. Supreme Court in the litigation over whether Puerto Rico’s Public Corporations Debt Enforcement and Recovery Act, an insolvency statute for certain of its government instrumentalities, is void, as the lower federal courts held, under Section 903 of the U.S. Bankruptcy Code:

It is said that muddy water is best cleared by leaving it be. The Supreme Court’s December 4 decision to review the legality of Puerto Rico’s local bankruptcy law, the Recovery Act, despite a well-reasoned First Circuit Court of Appeals opinion affirming the U.S. District Court in San Juan’s decision voiding the Recovery Act on the grounds that it conflicts with Section 903 of the U.S. Bankruptcy Code, suggests, at a minimum, that at least four of the Justices deemed the questions raised too interesting to let the First Circuit have the last word. This discretionary granting of Puerto Rico’s certiorari petition further muddies the already roiling Puerto Rican waters.

The Supreme Court has spoken once again on the limited jurisdiction of the bankruptcy courts, adding to the understanding derived from previous cases. Wellness International Network, Ltd., et al. v. Sharifis the Supreme Court’s sixth significant case exploring bankruptcy court jurisdiction under the Bankruptcy Code. For a brief and simplified history of bankruptcy jurisdiction jurisprudence shaped by these prior decisions, please jump to our prior advisory on this issue here.

In its previous decision in Executive Benefits Insurance Agency v. Arkinson, the Supreme Court left open two major issues: first, whether a creditor could impliedly consent to bankruptcy court jurisdiction to enter a final order by participating in the case without objection; and second, whether consent (express or implied) to jurisdiction to enter final orders is even valid under the Constitution. On the second issue, 28 U.S.C. §157 specifically provides the opportunity for all parties to consent and for the bankruptcy court to finally decide the matter. As we saw in Stern, however, that language does not make such a grant of jurisdiction constitutional.

The Court in Wellness went a long way toward answering these two questions. Wellness determined that Article III of the Constitution is not violated when the parties knowingly and voluntarily consent to adjudication of “gap” claims under Stern. “Gap” claims are those claims that are designated by statute as “core” issues but that cannot be treated as “core” because of the constitutional limits of bankruptcy court jurisdiction. After Wellness, there every reason to think that parties can consent on “non-core” and “related to” matters as well. Continue Reading Did The Supreme Court Finally Explain Stern? Examining the Wellness of Bankruptcy Court Jurisdiction

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